The recent market correction has not spared even the ‘defensive’ pharma stocks. The BSE Healthcare Index has lost over 11 per cent since early November. But the sharp correction offers a buying opportunity in select stocks with good long-term growth prospects. The stock of Dr Reddy’s is among these.

Regulatory issues at three of the company’s manufacturing facilities has unnerved investors; the stock has shed over 30 per cent since early November and now trades at the lowest level in the last one year.

The company’s three facilities located in Andhra Pradesh and Telangana have been served warning letters by the US drug regulator, Food and Drug Administration (FDA), citing lapses in operating procedures and documentation.

While the regulatory overhang is a sentiment dampener for the stock, the correction has more than factored in the potential loss in revenue and profit on account of this.

These three facilities contribute about 10-12 per cent of the company’s revenue. The warning letter does not prohibit the company from supplying drugs from these plants to the US and, hence, ensuring swift remedial action will be important at this point to prevent an import ban on these facilities.

At the current price, the stock trades at about 17 times its expected 2016-17 earnings, implying a 20 per cent discount to the BSE Healthcare Index and an over 25 per cent discount to peers Sun Pharma and Lupin.

Remedial measures Though resolution of regulatory issues will be paramount for Dr Reddy’s to achieve healthy revenue and profit growth over the next one to two years, initiatives such as transferring drug applications to an alternative facility and procuring supplies from third parties should mitigate any negative impact.

Also, the management has committed to bringing these facilities back on track and has initiated remedial measures. Further, a good pipeline of generic and proprietary and biosimilar products and steady performance in other key geographies such as India should help the company. Investors with a three-year horizon can use the current weakness to buy the stock.

In November 2015, the US FDA issued a warning letter on the company’s active pharmaceutical ingredient (API) manufacturing facilities at Srikakulam (Andhra Pradesh) and Miryalaguda (Telangana), and oncology formulation facility at Duvvada, Visakhapatnam, Andhra Pradesh.

The issues highlighted by the regulator in the warning letter include slippages in documentation and control, laboratory testing practices and standard operating procedures. The regulator has also mandated third-party evaluation of the quality systems at these facilities.

While the warning letter does not restrict the company from manufacturing and supplying drugs from these facilities to the US, lower production due to remedial measures and delay in approvals for products that have been filed from this facility may impact the company’s performance.

Products made in these facilities accounted for about 10-12 per cent of the company’s revenue in 2014-15, according to the management. The management has committed to swift remedial action and ensuring quality compliance. Meanwhile, it has initiated steps to de-risk its US business. For instance, the company is working on site transfer for some of its key products. For its injectable products, the company is exploring the option of outsourcing the product either partially or fully.

For some of its key products such as generic version of anticancer drugs, Vidaza and Dacogen, the company is already sourcing bulk of the supplies from third-party manufacturers.

These should minimise the adverse impact arising out of regulatory issues. Further, the company also has a promising pipeline of generic, biosimilar and proprietary products, the approvals for which should start coming over the next two-three years.

These should help Dr Reddy’s sustain good growth over the next three to five years.

Growth in revenue The company’s business in the home market has stabilised over the last several quarters. The domestic revenue has grown from low single-digits a couple of years ago to healthy double-digit. New launches and acquisition of generic portfolio of Belgium-based drug maker UCB should help Dr Reddy’s sustain growth in the Indian market.

For the six months ended September 2015, the company’s revenue grew 9 per cent, compared with the same period in 2014. Operating profit margin improved by 4.3 percentage points to 28.6 per cent during the first six months of the fiscal.

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